Market Outlook 2009 - Thoughts of a Professional Investor

Many highly successful traders exercise their skills within a framework of
fundamental analysis. Given that lesson, I like to take reflection time at
the beginning of each year to establish macro themes around which I can trade.
One year is a relatively short time with regard to macroeconomic themes. Scenarios
typically develop over much longer periods, building as events unfold and psychology
shifts. In addition, time unfolds within a trader's imagination at a much faster
pace than in reality. In other words, one's fundamental analysis may be thorough
and one's conclusions accurate, yet the scenarios envisioned may not come to
fruition for quite a bit longer than anticipated. A trader must invoke patience
and pay close attention to market signals, not only to trade at the right time
but also to not trade at the wrong time.

Many of the expectations outlined below have been discussed in daily posts
to my market blog.

Macroeconomic Backdrop
In 2008, the tremendous misallocations of resources built up due to excessive
credit expansion during the housing bubble finally produced the long-expected
panic and crisis. It is important to note that panic and crisis are not the
same. Panics are emotional events... reactions to news that may or may not
have any lasting effect on economic activity ... whereas crises deal with
concrete restrictions on economic activity, whether it be lack of credit
or a dearth of natural resources.

It is academic to try to pinpoint exactly when a crisis begins, but it is
safe to say that by the time Bear Stearns collapsed in March, we were entrenched
in our current crisis. The panic came in autumn (who would have guessed?) with
the stock market meltdown. Crises tend to last anywhere from days to years
after the manifestations of panic, depending on the scope of the preceding
resource mismanagement. Given the current situation, it would be hard to imagine
recovery occurring directly after the panic. In fact, 2009 is likely to be
remembered for soaring unemployment, massive waves of bankruptcies, and scores
of bank failures.

Just how big is the problem? Well, take a look at its foundation. From 1995
to 2000, unmitigated monetary expansion created a stock market bubble which
sent the S&P 500 from 450 to 1550. The ensuing recession... and they always
come when resources are misused... promised to be nasty. By 2002, the SPX had
fallen back to 750. If healthy market forces had been allowed to do their work,
the entire bubble would have been unwound, a few inefficient blue chips would
have folded, and lots of smaller inefficient companies would have followed.
To the chagrin of policy makers, prices of goods and services would have dropped
(I like lower prices. Don't you?), resources would have returned to higher
utility, and by now Americans would have been enjoying a productive (rather
than speculative) economy along with a selection of bargain stocks with promising
futures.

Instead, the Federal Reserve forced more credit down our throats and induced
an even larger bubble. While the tech bubble's scope was measured in the hundreds
of billions, the housing bubble dwarfed it. Tens of trillions of dollars were
tossed around the globe in the forms of ill-advised loans and ill-advised derivatives
on those loans. Yet despite its enormity, the housing bubble only managed to
push the S&P 500 back to nominal highs. Why? Because it was all
a fraud. Real wealth cannot be created simply by printing money. The housing
boom was soaking up resources that would have been more efficiently used elsewhere
or even left in the ground. Inefficient businesses thrived because they had
access to capital at below-market price. We basically robbed our future resources
simply for the guise of economic activity.

We are now entering a period of depression, in the classic economic sense,
in which debt is detroyed, prices fall, and inefficient businesses... except
those fraudulently supported by governments... fail. I do not believe that
any government action can prevent this process from unfolding. Efforts by western
central banks to force more credit creation will change nothing but the level
of inflation economies suffer when expansion returns. Furthermore, reactionary
antics by a new set of politicians are likely to deepen the coming depression
through inefficient policies of regulation, taxation, and price controls.

Stocks
With such a backdrop, it is highly unlikely the stock market has seen a low.
I firmly believe the current rally out of November will fail sometime in
the first quarter. I do not expect another panic, however. It seems more
probable that the market suffers a slow erosion brought on by forced liquidation
as unemployment rises and hope that government action will succeed slowly
fades. I expect the stock market to end the year below the November 2008
low, but just how far below will depend on many factors, not the least of
which is the extent of government interference.

Bonds and The Dollar
The quantity of money being created by the Fed in response to credit contraction
will ensure that all other dollars in existence will be worth significantly
less. However, in times of crisis people want safety, and the ultimate perception
of safety still comes in the form of U.S. Treasuries which, by the way, are
still sold for U.S. dollars. Add to this natural allure the fact that the
Fed has explicitly stated its intention of depressing long rates, and one
has the formula for a bond run and by extension, a dollar run. In conjunction
with the deflationary forces of debt destruction and depressed economic activity,
we now have the luxury of lower prices.

This luxury will not last. Market forces will eventually discipline the Fed
through a combination of higher rates and inflation. The turning point will
also mark a secular trend change for bonds, which have enjoyed a 27-year bull
market. It is possible that the recent run carries the signature of the parabolic-style
move that ends such long-term bulls. I suspect we will see the inflection during
the course of 2009. With regard to the bond market's effect on stocks, the
recent flood of money into bonds has likely stunted the extent of the stock
market rebound out of November. Ironically, if bonds fall fast enough, the
rise in rates could likewise stunt stock performance.

Commodities
There is no doubt that the monetary expansion being executed by central banks
will lead to a painful level of inflation in coming years. However, inflation
typically coincides with credit expansion. In other words, current monetary
policies are not having the desired effect, nor will they be efficacious
until the global economy finds a footing. As implied above, I have serious
doubts that such a turn will occur this year. It is therefore unlikely that
commodities will cycle back into bull mode during 2009. It will be a trader's
market, and any rallies should be shortable. Industrial commodities such
as energy and non-precious metals should remain especially weak. However,
I suspect gold will continue holding relative strength versus all other commodities
in anticipation of the coming inflationary phase.

Deric O. Cadora is the editor of The DOCument, a daily newsletter offering
equity and commodity market cycles analysis, macroeconomic discussion, and
general market commentary. Deric is a professional trader and a General Partner
of The Rutledge Group, a managing partner of a commodity-centric investment
partnership. His investment and trading experience spans two decades, during
which time he formed and served as principal of a broker-dealer, managed a
long/short book on the proprietary trading desk of Citi Capital Markets, worked
as an independent trader, and currently serves as Chief Portfolio Manager for
a commodity-centric investment partnership.